I’m reading a lot about how the VC model is dead, and the venture capital industry is drying up. Supposedly, this is caused by the lack of conventional exits and liquidity events, meaning the venture capital funds can’t return cash to their investors. While we are clearly going through a flat spot in IPOs, and the world of acquirers is reduced, I’m not sure that implies the industry is dead. I think it’s just going through a stretched out phase.
In the VC conferences, you see graphs of how much money is going into the funds, how much is being invested in early and late stage deals, how many deals are being done and how many exits are happening. Inside the fund meetings, there is always a lot of talk about Deal Flow: how many deals are we seeing, are we seeing the best deals or the dregs, how many are competitive deals where multiple funds are bidding up the price. And in the board rooms of our investments, we talk about cash flow and burn rates. Everywhere you look, the issue is the flow of money from one place to another, and accumulating in the chosen few winners. It’s all about Flow.
I want to talk about another abstract measure of the new venture business that I call Idea Flow. What is Idea Flow? Simplistically, it is the rate at which new ideas are being generated. And what is it a function of?
Well I think it is partly a function of population growth, and the number of fresh minds entering society from the bottom, for example the number of college graduates. Each young mind is taking a fresh look at the world and seeing it from a slightly newer perspective.
In addition, I think it is also a function of how far we have gone in digesting the last few major revolutions. For example, the concept of the Internet, and frictionless communication at negligible cost, this is a revolution that is clearly still happening. When there are major revolutions percolating through society that haven’t been fully exploited yet, then the Idea Flow rate is probably enhanced.
Finally, Idea Flow is a function of whether sufficient resources are available to gestate these ideas. Maybe this should be a slightly different concept, say Manifest Idea Flow. In other words, maybe just having an Idea isn’t enough. We also need to let it bloom or it’s meaningless.
I’m sure one can identify other contributors to the rate of Idea Flow. My point here is that basic Idea Flow is clearly still growing. The number of college graduates continues to rise each year, and the population continues to grow in all but the most extreme cases of deprivation. And we have experienced at least three major revolutions in the past few decades that are still playing themselves out. Information Technology (computers, memory, programming, AI), Biotechnology (genome mapping, molecular biochemistry, synthetic biology), Communication Technology (the Internet, email, texting, cellphones), these are three overlapping general categories of revolution in process.
I think Idea Flow is the bedrock of the Venture business. Without ideas, nothing can be created. You might as well buy Ma Bell and cash your dividend checks quarterly. The Venture Capital business starts with a couple of motivated entrepreneurs, a problem that needs solving and an Idea.
I believe that in this time of economic turmoil, where cash flow and economic growth and investment capital are down substantially, the bedrock of the Venture Capital business is still healthy. If anything the current turmoil makes aspects of our economy more ripe for disruption. If the old ways are broken, let’s try a new way.
A larger number of bright young minds are emerging each year, and the ground is fertile. And today it often takes less capital than ever before to manifest an idea.
So I’m bullish on the Venture Capital business right now. While others say it is dead or broken, I think it is likely to be even more fertile in the coming few years. Valuations are down and the potential for profit is therefore up. The markets are more vulnerable to disruption. And the public investor is always interested in an exciting story of the future realized. The IPO market in some form will reopen soon, perhaps even in 2009. And large companies will emerge from this downturn with their existing market approaches damaged, and needing new ways to continue growth. They will be acquiring again.
In the end, this business is about Idea Flow, and it’s still healthy.
Thursday, December 4, 2008
Monday, November 24, 2008
Episode 5.1. More musing on Exits.
I’ve been thinking more about exits. It is in down times like these that revolutionary ideas often find traction. During flush times, people are not incentivized to try a new approach --- they just want to keep doing what is working. But when things aren’t working, those same people will be open to a new approach. There is little to lose.
Well, the exit process isn’t working right now, period. New businesses are not being taken to the public markets. One way to look at it is the stock variety you can invest in has remained fixed or shrunk over the past couple of years. When new ideas – new businesses have emerged they have either stayed private or been bought by bigger companies and absorbed.
I have the impression that the public investor has an appetite for flyers, has a desire to invest a small portion of their money in a risky new idea with huge growth potential. It may only be a small portion of their pile, but like the endowments that fund venture capital, the public investor wants to allocate a few percent of their investments to a sexy new idea. I think this interest never dies. And I think it is an itch that hasn’t been scratched recently. In the midst of the market melt down, I propose there remains a latent demand for IPOs. It may be smaller now that in 2000 (much smaller), but it’s not zero.
So here’s a wild prediction: I predict the IPO market will return in 2009. However, I predict it will come back in a new way. The old way involved investment banks running the show and underwriting the offering. Half those investment banks no longer exist or half been consumed and morphed into some new entity with an entirely different business model. I doubt that model will return soon. But there was a lot of experimentation with the Dutch Auction method during the past decade. It seemed to be ideally positioned to maximize benefit for the company and minimize benefit for the investment banks and their inside clients. It worked for Google. But there was a lot of criticism of it subsequently, I suspect driven by those investment banks who didn’t like being effectively disintermediated.
Well I wonder if this model is poised to come back strong in the coming year. Those banks are on their heels and struggling with their own problems. And there has been a subtle change in people’s impression of online finance. Witness the extraordinary success Obama had fundraising online. Half a billion dollars was raised online in this past year’s campaign. I think the public perception of the Internet as a financial conduit has matured. People seem to believe they can trust the Internet as much as the telephone or the television in the conduct of their daily lives.
So I think the idea of a Dutch Auction run on the Internet, with copious information equally available to everyone, is an idea who’s time has come. And I'm beginning to suspect that 2009 is that time, and especially ripe for this kind of revolution. I’m going to try to develop this idea further in subsequent postings.
Well, the exit process isn’t working right now, period. New businesses are not being taken to the public markets. One way to look at it is the stock variety you can invest in has remained fixed or shrunk over the past couple of years. When new ideas – new businesses have emerged they have either stayed private or been bought by bigger companies and absorbed.
I have the impression that the public investor has an appetite for flyers, has a desire to invest a small portion of their money in a risky new idea with huge growth potential. It may only be a small portion of their pile, but like the endowments that fund venture capital, the public investor wants to allocate a few percent of their investments to a sexy new idea. I think this interest never dies. And I think it is an itch that hasn’t been scratched recently. In the midst of the market melt down, I propose there remains a latent demand for IPOs. It may be smaller now that in 2000 (much smaller), but it’s not zero.
So here’s a wild prediction: I predict the IPO market will return in 2009. However, I predict it will come back in a new way. The old way involved investment banks running the show and underwriting the offering. Half those investment banks no longer exist or half been consumed and morphed into some new entity with an entirely different business model. I doubt that model will return soon. But there was a lot of experimentation with the Dutch Auction method during the past decade. It seemed to be ideally positioned to maximize benefit for the company and minimize benefit for the investment banks and their inside clients. It worked for Google. But there was a lot of criticism of it subsequently, I suspect driven by those investment banks who didn’t like being effectively disintermediated.
Well I wonder if this model is poised to come back strong in the coming year. Those banks are on their heels and struggling with their own problems. And there has been a subtle change in people’s impression of online finance. Witness the extraordinary success Obama had fundraising online. Half a billion dollars was raised online in this past year’s campaign. I think the public perception of the Internet as a financial conduit has matured. People seem to believe they can trust the Internet as much as the telephone or the television in the conduct of their daily lives.
So I think the idea of a Dutch Auction run on the Internet, with copious information equally available to everyone, is an idea who’s time has come. And I'm beginning to suspect that 2009 is that time, and especially ripe for this kind of revolution. I’m going to try to develop this idea further in subsequent postings.
Saturday, November 15, 2008
Who are those guys? What makes a good VC. Final Episode 5
It’s taken me a few months to get to this fifth installment. I was stalled at first because there hadn’t been a lot of “Exiting” going on in the past year or two. And I had the feeling the concept of Exit was undergoing change. Then we experienced the economic meltdown of the past two months. Like other active VCs, my fund responded by focusing our attention on our current investments, helping them position themselves to weather the downturn. So I apologize to those of you who emailed wondering if I had died or something. No, I’ve just been very busy, and a little reflective on my subject.
The classical view of venture capital is that a VC invests in a company, grows it into revenue and breakeven, and then sells equity in it to the public in an IPO. The exit part is the VC’s can then sell their ownership interest in the startup to that public market of buyers as the company grows in value, or distribute their now-liquid shares to their limited partner investors to sell. Either way, there is a rotation of the early investors out of the stock and new public investors into the stock. In a prototypical case, a venture fund may have put a total of $10M into a startup and owns 25% of it, and later when it goes IPO, that 25% is worth $250M and the VC gets a 25x return on their investment. The buyers in IPOs were typically trying to buy into rapid initial growth from new businesses. Or they were trying to buy in early to a speculative bubble, and get out before it sank back to earth. This is what was driving much of the bubble economy of 8 years ago.
A common alternative to the IPO exit route was getting the startup acquired by a bigger company, a so-called Mergers & Acquisitions or M&A exit. This could directly result in a cash return if it was a cash acquisition, or it could involve stock in the acquiring company that might yield immediate or near term liquidity. When the so-called “IPO window” was closed, i.e. IPOs were not getting done on Wall Street, the acquisition route was the preferred backup plan for VCs. Frequently the IPOs might be failing but large acquiring companies might still be looking for new lines of business or revenue growth from startups. In the past couple of years, acquisition or “M&A” exits have been much more common.
We now live in extraordinary and seemingly unique times. It is doubtful that an IPO market will come back soon. The public market has been burned by a steep drop in values across the board. Many investors will not trust the markets for some years to come. Buying into a speculative IPO of a company with a short track record in a new market may be too much to ask of investors. There has clearly been a flight from risk, but unfortunately no risk-free place to turn. Many argue that the smaller, nimbler, trendier companies will recover more value as we come out of this downturn, but I’m not sure that will apply to IPOs.
Why do Venture Capitalists need Exits in the first place? Because they are the opposite of Warren Buffett, they are constitutionally unable to be in it for the long term. They raise their funds by making a promise to their limited partner investors that they will return much greater value to them within 10-12 years and more desirably, in 5-7 years. VCs can be seen as relatively short term, high risk investment agents for their LPs. They (hopefully) intelligently direct an endowment’s money to the best early stage investments, and relatively quickly hand back a liquid return.
I’ve been reflecting on the best way to do that in our current economic climate. Some pundits have argued that the VC world has fundamentally changed, mostly because the traditional exit strategies have become untenable. How do you invest in a start-up and get to liquidity so you can distribute to your LP investors if there is no IPO market and a seemingly limited number of acquirers. The joke around the Silicon Valley was the only exit strategy was a “GYM” strategy, i.e. sell to Google, Yahoo, or Microsoft. But there is a limit to what even these companies will buy, especially in these times, and especially if it Microsoft buys Yahoo.
So I’ve been pondering alternative exit strategies or holding actions until the traditional exits come back. For example, I have the impression that in a lot of markets there are too many startups addressing market niches that can’t support them all. In a tight market of investment capital, there may be more room for, and a need for, creative mergers of early stage companies. Maybe startup teams need to merge with other startups addressing the same markets. In effect, the two startup’s investment syndicates need to join forces to address a shared market interest with their collective teams. The danger of having too many spread-out competitors is that NOBODY survives because they are forced to resort to desperate competitive tactics. Merged together, they can more efficiently address their market niche and combine the best features of each one’s original offering. There is no doubt that this means redundancy will be trimmed and teams will be smaller. But that makes more sense than a war of attrition where no one survives.
What I’m thinking about here is something like a bottoms-up roll-up strategy. Earlier stage companies may need to look at their competitors as partners to join up with. The investor groups end up diluted but owning the best of both companies and with more syndicate partners and probably more money and staying power around the table. The resulting consolidated company benefits by having less mutually destructive competition in their niche. The market benefits by getting a more rounded product offering from a better-positioned company. There will obviously be some egos bruised as two entrepreneurial, aggressive start-up teams are merged and trimmed. But it’s a survival strategy in a down market, probably makes a company more fundable, and is a better outcome than getting shut down.
Obviously there are reasons why this strategy doesn’t work in all situations. Frequently neither company has enough money to survive much longer. The old aphorism that “tying two stones together won’t make them float” certainly applies here. But when an VC investor group is faced with doing an inside round or a bridge to one of their start-up companies because there isn’t enough capital in the company or there isn’t an attractive exit, but there IS the gist of a good company, maybe that is a good time to look at the competition and try to craft a creative merger. The result may be more fundable.
This posting has morphed into more of a discussion about exits in our current climate than about what makes a good VC. I do want to finish this series on what makes a good VC from an exit perspective. But given the above discussion, my bias in the coming paragraphs will be on deal-making skills rather than IPO/investment banking skills.
A good VC is helping their start-up team deal with operational challenges as they build their company. Since the majority of venture-backed companies will fail or exit at below their cash-in value, the majority of exits a VC must execute on may be under less than advantageous terms. A “dealmaker” mentality succeeds best in these situations, i.e. that individual who knows how to read the acquirer’s needs and get the most for their start-up by positioning it to meet those acquirer’s needs. It is salesmanship.
Other previously mentioned skills like a big rolodex are obviously valuable here. And VCs that have previously backed now very successful acquirers (think Google) can often have better luck selling their subsequent start-up companies to that earlier success. They know the management and key opinion leaders in the acquirer. Frequently those senior managers may even be limited partners in that fund.
I doubt there will be many IPOs in the coming couple of years. The skills that make a VC successful in a world of IPO exits aren’t likely to be useful now. They aren’t that different than what is valued in an M&A exit world. It may be important for a VC to understand some of the foreign exchanges that have been able to provide IPO exits in the past couple of years. Toronto and London exchanges were getting IPOs done a few years ago, so a VC with good international experience and even overseas partners might have been at an advantage then. But those days are over now.
My next posting will try to summarize this 5 episode rumination on what makes a good VC. I’m looking forward to talking more about how the VC world is evolving as it matures and adapts to changing economic times.
Thanks for waiting.
The classical view of venture capital is that a VC invests in a company, grows it into revenue and breakeven, and then sells equity in it to the public in an IPO. The exit part is the VC’s can then sell their ownership interest in the startup to that public market of buyers as the company grows in value, or distribute their now-liquid shares to their limited partner investors to sell. Either way, there is a rotation of the early investors out of the stock and new public investors into the stock. In a prototypical case, a venture fund may have put a total of $10M into a startup and owns 25% of it, and later when it goes IPO, that 25% is worth $250M and the VC gets a 25x return on their investment. The buyers in IPOs were typically trying to buy into rapid initial growth from new businesses. Or they were trying to buy in early to a speculative bubble, and get out before it sank back to earth. This is what was driving much of the bubble economy of 8 years ago.
A common alternative to the IPO exit route was getting the startup acquired by a bigger company, a so-called Mergers & Acquisitions or M&A exit. This could directly result in a cash return if it was a cash acquisition, or it could involve stock in the acquiring company that might yield immediate or near term liquidity. When the so-called “IPO window” was closed, i.e. IPOs were not getting done on Wall Street, the acquisition route was the preferred backup plan for VCs. Frequently the IPOs might be failing but large acquiring companies might still be looking for new lines of business or revenue growth from startups. In the past couple of years, acquisition or “M&A” exits have been much more common.
We now live in extraordinary and seemingly unique times. It is doubtful that an IPO market will come back soon. The public market has been burned by a steep drop in values across the board. Many investors will not trust the markets for some years to come. Buying into a speculative IPO of a company with a short track record in a new market may be too much to ask of investors. There has clearly been a flight from risk, but unfortunately no risk-free place to turn. Many argue that the smaller, nimbler, trendier companies will recover more value as we come out of this downturn, but I’m not sure that will apply to IPOs.
Why do Venture Capitalists need Exits in the first place? Because they are the opposite of Warren Buffett, they are constitutionally unable to be in it for the long term. They raise their funds by making a promise to their limited partner investors that they will return much greater value to them within 10-12 years and more desirably, in 5-7 years. VCs can be seen as relatively short term, high risk investment agents for their LPs. They (hopefully) intelligently direct an endowment’s money to the best early stage investments, and relatively quickly hand back a liquid return.
I’ve been reflecting on the best way to do that in our current economic climate. Some pundits have argued that the VC world has fundamentally changed, mostly because the traditional exit strategies have become untenable. How do you invest in a start-up and get to liquidity so you can distribute to your LP investors if there is no IPO market and a seemingly limited number of acquirers. The joke around the Silicon Valley was the only exit strategy was a “GYM” strategy, i.e. sell to Google, Yahoo, or Microsoft. But there is a limit to what even these companies will buy, especially in these times, and especially if it Microsoft buys Yahoo.
So I’ve been pondering alternative exit strategies or holding actions until the traditional exits come back. For example, I have the impression that in a lot of markets there are too many startups addressing market niches that can’t support them all. In a tight market of investment capital, there may be more room for, and a need for, creative mergers of early stage companies. Maybe startup teams need to merge with other startups addressing the same markets. In effect, the two startup’s investment syndicates need to join forces to address a shared market interest with their collective teams. The danger of having too many spread-out competitors is that NOBODY survives because they are forced to resort to desperate competitive tactics. Merged together, they can more efficiently address their market niche and combine the best features of each one’s original offering. There is no doubt that this means redundancy will be trimmed and teams will be smaller. But that makes more sense than a war of attrition where no one survives.
What I’m thinking about here is something like a bottoms-up roll-up strategy. Earlier stage companies may need to look at their competitors as partners to join up with. The investor groups end up diluted but owning the best of both companies and with more syndicate partners and probably more money and staying power around the table. The resulting consolidated company benefits by having less mutually destructive competition in their niche. The market benefits by getting a more rounded product offering from a better-positioned company. There will obviously be some egos bruised as two entrepreneurial, aggressive start-up teams are merged and trimmed. But it’s a survival strategy in a down market, probably makes a company more fundable, and is a better outcome than getting shut down.
Obviously there are reasons why this strategy doesn’t work in all situations. Frequently neither company has enough money to survive much longer. The old aphorism that “tying two stones together won’t make them float” certainly applies here. But when an VC investor group is faced with doing an inside round or a bridge to one of their start-up companies because there isn’t enough capital in the company or there isn’t an attractive exit, but there IS the gist of a good company, maybe that is a good time to look at the competition and try to craft a creative merger. The result may be more fundable.
This posting has morphed into more of a discussion about exits in our current climate than about what makes a good VC. I do want to finish this series on what makes a good VC from an exit perspective. But given the above discussion, my bias in the coming paragraphs will be on deal-making skills rather than IPO/investment banking skills.
A good VC is helping their start-up team deal with operational challenges as they build their company. Since the majority of venture-backed companies will fail or exit at below their cash-in value, the majority of exits a VC must execute on may be under less than advantageous terms. A “dealmaker” mentality succeeds best in these situations, i.e. that individual who knows how to read the acquirer’s needs and get the most for their start-up by positioning it to meet those acquirer’s needs. It is salesmanship.
Other previously mentioned skills like a big rolodex are obviously valuable here. And VCs that have previously backed now very successful acquirers (think Google) can often have better luck selling their subsequent start-up companies to that earlier success. They know the management and key opinion leaders in the acquirer. Frequently those senior managers may even be limited partners in that fund.
I doubt there will be many IPOs in the coming couple of years. The skills that make a VC successful in a world of IPO exits aren’t likely to be useful now. They aren’t that different than what is valued in an M&A exit world. It may be important for a VC to understand some of the foreign exchanges that have been able to provide IPO exits in the past couple of years. Toronto and London exchanges were getting IPOs done a few years ago, so a VC with good international experience and even overseas partners might have been at an advantage then. But those days are over now.
My next posting will try to summarize this 5 episode rumination on what makes a good VC. I’m looking forward to talking more about how the VC world is evolving as it matures and adapts to changing economic times.
Thanks for waiting.
Thursday, April 10, 2008
Who are those guys? What makes a good VC. Episode 4
1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit
The previous three stages are earlier posts below. This is stage 4, where I am talking about the time after making a venture investment and building value in the startup, in preparation for an exit. This is the operational part of the job --- how do you help a startup succeed? I should disclose in advance that I am a believer in venture capitalists who are actively involved with their companies, who require board of director roles, and who keep in frequent touch with the startup team. There are VC funds that function as silent, hands-off players and follow other investors leads. The following really doesn't apply to them.
In my humble opinion, the best VCs are those that have an operating background. Starting a company presents the entrepreneur with a range of complex problems and decisions that have to be made. The best VCs are ones that have confronted these issues in their own careers. For example, a balance has to be struck between frugality and audacity. A thrifty startup fosters a healthy company culture and focuses the majority of spending on areas that increase the value of the enterprise and the likelihood of success. On the other hand, knowing when to hit the accelerator and spend the money for the greatest effect, that is a challenge that every entrepreneur faces. It really helps to have backers and VCs who’ve done that before.
And there are a host of seemingly minor administrative decisions a startup needs to address, e.g. payroll, benefits, facilities, accounting, legal, IP protection, capital equipment, hiring… Experienced entrepreneurs have encountered these issues in their past startups. They make the best VCs in my humble opinion during this stage.
One key challenge is transitioning a founding team into a management structure that can grow the business. Frequently, founding team members “get ahead of themselves” and get set on how they are the right people to lead this venture to the promised land. They see themselves as the next Scott McNealy or Steve Jobs, i.e. the founder that took the company all the way to billions in revenue. Or a cofounder has gotten comfortable with a lofty title and responsibility area and doesn’t want his role reduced or narrowed. Or the founders have brought along one of their fraternity buddies as a co-founder, mostly because he’s a long-time drinking buddy, but who has no qualifications for the job he envisions for himself.
A great stage 4, “operating” VC will be adept at building a sensible and scalable management structure from the founding team, without disrupting the operation or culture of the startup. Almost more importantly, a good operating VC will mentor the founding team members so that they see and buy into the wisdom of this management structure.
This is one of the most challenging aspects of investing in and helping manage a startup: managing individual egos and expectations to maximize the overall value of the enterprise. By definition, to have the courage to start a company from nothing but an idea requires a big ego and almost an irrational determination to succeed. But the VC is investing in the overall enterprise more than the individual egos of the founders. Sensitively managing those egos for the overall benefit of the organization (and everyone's investment or time or money) is a truly important skill for a VC at this stage.
Another key value that an operating VC can and should offer to a post-investment startup is introductions to key contributors, i.e. partners, customers, key hires, etc. That means it is important for the VC to have a full rolodex, which again favors VCs with long operating histories.
Perhaps the hardest to quantify but ultimately most important addition a good operating VC can offer to a startup team is rational and reasoned advice and criticism on strategy. An operating VC in this stage, typically also serving as a board member, is ideally suited to give the entrepreneur advice that is not biased by the day-to-day "drinking of their own Kool-aid" that an aggressive startup team may suffer from. A great operating VC can give the team perspective and balance, at least partly from an outsider’s perspective at those monthly or quarterly board meetings, and intervening contacts.
Finally, once a VC is invested in a startup, one of their key tasks is to bring in follow-on financing and new venture capital firms to lead those rounds. That means coaching a startup team to do a great venture presentation. It is ironic that now the VC is coaching the team on how to best sell their deal to other VCs. But it is further ironic that VCs are often particularly good at this coaching. They see lots of deals and they know a good pitch when they see it. They know what sells THEM on a deal. But a great VC can often help an entrepreneur position their deal relative to all the other competing deals out there that a follow-on VC might be seeing.
So to summarize, in this stage a good VC is bringing operating experience, mentoring, a good rolodex of contacts, team-building and human resource skills, strategic thinking, a balanced “semi-outsider’s” perspective, and coaching on how to best raise more money.
Sunday, February 3, 2008
Who are those guys? What makes a good VC. Episode 3
This is the very belated third installment of my running saga about what makes a good VC. I have previously laid out a framework for identifying the skills that make a good VC, in rough chronological order through the process. Each installment covers a stage:
1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit
So here’s stage 3, a discussion of the skills involved in executing an investment that make a good venture capitalist.
This is the stage where the rubber meets the road. The previous two stages were window shopping. Here the VC is buying. The VC’s goal is to buy a share of the startup at the best possible price in return for his investment capital. But it isn’t quite that simple. For that investment to actually pay off, the VC needs to incentivize the entrepreneur and help grow the business. It is a very rare business where a VC can add funding and any idiot can turn it into a large multiple. First, there are no certainties. Second, every startup needs motivated, intelligent people to grow the business and realize a big increase in value. Finally, pretty much every startup entrepreneur needs experienced advice and critical contacts to fully realize that big increase in value.
So a good funding deal is one that leaves everybody incentivized to grow the company. If that doesn’t happen then everyone will equally share the loss. A VC who drives too hard of a bargain, and leaves the entrepreneur with too little of the upside, risks undermining the founders’ determination to put everything into the business. On the other hand, a VC who puts too high a value on the premoney of the startup, and therefore takes too small a share of the ongoing profit, will not last long in the competitive VC world. Further, they may make it harder for the entrepreneur to attract further investment in a later round by unreasonably inflating the entrepreneur’s expectations on valuation.
The entrepreneur is at a disadvantage. They are lucky to have a buyer. In contrast the VC sees plenty of deals, dozens a week, and will only fund less than 1% of the deals he sees. And there is the “golden rule”, i.e. whoever has the gold makes the rules. Only very rarely does an entrepreneur have exclusive control of such a disruptive idea that they can dictate terms to a host of VCs. Usually, the VC sets the terms and the entrepreneur can only improve them by generating some competition for their deal. And VCs will usually work happily together in a syndicate, and tend to know each other in their focus areas, so even the competition strategy can be hard to execute.
I’m arguing here that a good VC is thinking about the long term success of the deal, and not so much about extracting the maximum amount of benefit for his fund. In most cases, a deal has a limited number of bidders who are focusing on that market area and could fund that deal. But I believe the VC who “sticks it” to the entrepreneur because he knows he can, because the entrepreneur needs his money more than he needs their deal --- that VC is really undermining his own chances for a long term success. The entrepreneurs need to have incentive to give the business EVERYTHING they’ve got. A good VC needs to strike that balance.
So a first key skill is balance and fairness, finding that right mix of founders’ incentive and investors return.
Another important aspect of getting a funding done is crafting the terms of the investment to fairly cover all of the eventualities. A termsheet is often filled with pages of clauses that attempt to cover every possible outcome. There is a lot of technician work here that is often based on hard experience by the VC or by their attorneys. VCs do carry an advantage in this phase, because they do a lot of termsheets and their attorneys are specialists in this phase. In contrast, many entrepreneurs are seeing a termsheet for the first time. True – they will hopefully also be represented by experienced attorneys, but the nature of the venture capital business is that only a minority of startups actually get financed, and even fewer have multiple financing options in front of them.
So another skill set (or maybe it is better described as hard won experience) is the ability to see all of the possible outcomes in a deal and anticipate them in the funding documents. When something happens downstream and it is completely unanticipated, that is usually a place where things will get ugly. It is better to try to anticipate even unlikely outcomes and try to agree in advance how they will be handled. Since most VCs have experience with failed companies, they are again more experienced here, compared to the entrepreneur. In fact, entrepreneurs are generally selected for funding because they DON’t have a lot of failure experience. But the nature of high-risk venture investing is that many (even most) VC deals will not turn out as planned. A competent VC knows the downsides.
My goal in this posting is to further explore what it takes to be a good VC. I’m not going to delve into the details of termsheet construction. But creating a fair, balanced and comprehensive termsheet is a key skill for a good venture capitalist.
There are also related skills in getting the deal done. Being able to reach out to syndicate partners where needed, and ironically to become the deal advocate, this is also an important skill. VCs often need to be able to “sell” as well as “buy” at this stage.
Also, a good VC needs to gain the confidence of the entrepreneur who is ultimately going to be his partner if the deal is consummated. It can be very challenging for a VC to gain the confidence and trust of an entrepreneur, while simultaneously pricing his deal and imposing all these arcane terms and worst-case scenario constructions on the deal. So I believe another key skill-set is to be a good communicator and negotiator.
So to sum up this episode 3, “Doing the Deal”, I think the key skills of a good VC are balance, fairness, experienced anticipation of downsides, communication, negotiation and openness that engenders trust in entrepreneurs. One must never lose sight of the fact that a VC is only successful when the startups he/she invests in are successful. Any behavior by a VC that hurts the chances that a deal will be successful is counterproductive and plain stupid. VCs must be ultra-confident to throw their money and reputations at completely unproven startups. Ironically, that ultra-confidence can easily lead them to be overly aggressive “cowboys”. Such behavior is ultimately not in their best interest if it disincentivizes their entrepreneur or scares off syndicate partners.
In the next Episode, the VC and the Entrepreneur are now ostensibly in the same boat, working toward the same end. We’ll see…
1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit
So here’s stage 3, a discussion of the skills involved in executing an investment that make a good venture capitalist.
This is the stage where the rubber meets the road. The previous two stages were window shopping. Here the VC is buying. The VC’s goal is to buy a share of the startup at the best possible price in return for his investment capital. But it isn’t quite that simple. For that investment to actually pay off, the VC needs to incentivize the entrepreneur and help grow the business. It is a very rare business where a VC can add funding and any idiot can turn it into a large multiple. First, there are no certainties. Second, every startup needs motivated, intelligent people to grow the business and realize a big increase in value. Finally, pretty much every startup entrepreneur needs experienced advice and critical contacts to fully realize that big increase in value.
So a good funding deal is one that leaves everybody incentivized to grow the company. If that doesn’t happen then everyone will equally share the loss. A VC who drives too hard of a bargain, and leaves the entrepreneur with too little of the upside, risks undermining the founders’ determination to put everything into the business. On the other hand, a VC who puts too high a value on the premoney of the startup, and therefore takes too small a share of the ongoing profit, will not last long in the competitive VC world. Further, they may make it harder for the entrepreneur to attract further investment in a later round by unreasonably inflating the entrepreneur’s expectations on valuation.
The entrepreneur is at a disadvantage. They are lucky to have a buyer. In contrast the VC sees plenty of deals, dozens a week, and will only fund less than 1% of the deals he sees. And there is the “golden rule”, i.e. whoever has the gold makes the rules. Only very rarely does an entrepreneur have exclusive control of such a disruptive idea that they can dictate terms to a host of VCs. Usually, the VC sets the terms and the entrepreneur can only improve them by generating some competition for their deal. And VCs will usually work happily together in a syndicate, and tend to know each other in their focus areas, so even the competition strategy can be hard to execute.
I’m arguing here that a good VC is thinking about the long term success of the deal, and not so much about extracting the maximum amount of benefit for his fund. In most cases, a deal has a limited number of bidders who are focusing on that market area and could fund that deal. But I believe the VC who “sticks it” to the entrepreneur because he knows he can, because the entrepreneur needs his money more than he needs their deal --- that VC is really undermining his own chances for a long term success. The entrepreneurs need to have incentive to give the business EVERYTHING they’ve got. A good VC needs to strike that balance.
So a first key skill is balance and fairness, finding that right mix of founders’ incentive and investors return.
Another important aspect of getting a funding done is crafting the terms of the investment to fairly cover all of the eventualities. A termsheet is often filled with pages of clauses that attempt to cover every possible outcome. There is a lot of technician work here that is often based on hard experience by the VC or by their attorneys. VCs do carry an advantage in this phase, because they do a lot of termsheets and their attorneys are specialists in this phase. In contrast, many entrepreneurs are seeing a termsheet for the first time. True – they will hopefully also be represented by experienced attorneys, but the nature of the venture capital business is that only a minority of startups actually get financed, and even fewer have multiple financing options in front of them.
So another skill set (or maybe it is better described as hard won experience) is the ability to see all of the possible outcomes in a deal and anticipate them in the funding documents. When something happens downstream and it is completely unanticipated, that is usually a place where things will get ugly. It is better to try to anticipate even unlikely outcomes and try to agree in advance how they will be handled. Since most VCs have experience with failed companies, they are again more experienced here, compared to the entrepreneur. In fact, entrepreneurs are generally selected for funding because they DON’t have a lot of failure experience. But the nature of high-risk venture investing is that many (even most) VC deals will not turn out as planned. A competent VC knows the downsides.
My goal in this posting is to further explore what it takes to be a good VC. I’m not going to delve into the details of termsheet construction. But creating a fair, balanced and comprehensive termsheet is a key skill for a good venture capitalist.
There are also related skills in getting the deal done. Being able to reach out to syndicate partners where needed, and ironically to become the deal advocate, this is also an important skill. VCs often need to be able to “sell” as well as “buy” at this stage.
Also, a good VC needs to gain the confidence of the entrepreneur who is ultimately going to be his partner if the deal is consummated. It can be very challenging for a VC to gain the confidence and trust of an entrepreneur, while simultaneously pricing his deal and imposing all these arcane terms and worst-case scenario constructions on the deal. So I believe another key skill-set is to be a good communicator and negotiator.
So to sum up this episode 3, “Doing the Deal”, I think the key skills of a good VC are balance, fairness, experienced anticipation of downsides, communication, negotiation and openness that engenders trust in entrepreneurs. One must never lose sight of the fact that a VC is only successful when the startups he/she invests in are successful. Any behavior by a VC that hurts the chances that a deal will be successful is counterproductive and plain stupid. VCs must be ultra-confident to throw their money and reputations at completely unproven startups. Ironically, that ultra-confidence can easily lead them to be overly aggressive “cowboys”. Such behavior is ultimately not in their best interest if it disincentivizes their entrepreneur or scares off syndicate partners.
In the next Episode, the VC and the Entrepreneur are now ostensibly in the same boat, working toward the same end. We’ll see…
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